Assessment Item 1: Group Assignment (20% of overall assessment; marked out of 100)
The great depression that began in the USA in 1929 saw a collapse in the financial markets with significant economic downturn and severe social ramifications associated with high level unemployment. During the last two decades, we have witnessed several great financial market failures, which including 1) The Failure of Barings Bank, 2) The Asian Financial Crisis, 3) The Global Financial Crisis, and 4) European debt crisis. In each of these crises you will see that underlying each crisis is the failure of risk management policy and practice. Please analyse and discuss the question ‘Will there be another financial crisis in the future?’
• examining the important factors that driving globalisation of the international ?financial markets; (10 marks)
• providing an analytical description of one or more financial crises that have occurred ?in the world’s economy; (20 marks)
• c. examining policy, structural and management issues that may create an environment that is conducive to an evolving financial crisis; (20 marks)
(1000 words)
untitled CHAPTER 12 CASE STUDIES IN FINANCIAL CRISES L e a rn i n g o b j e c t i v e s The relevant section of the chapter is provided in brackets beside the learning objective. This chapter will assist you to: LO 1. discuss important factors that are drivers of globalisation of the international fi nancial markets (12.1) LO 2. examine policy, structural and management issues that may create an environment that is conducive to an evolving fi nancial crisis, and understand the effects and consequences of a fi nancial crisis on a fi nancial system and a real economy (12.2) LO 3. identify and discuss risk management issues that were causal in the failure of Barings Bank (12.3) LO 4. identify the underlying fi nancial system weaknesses that became the precursor to the Asian fi nancial crisis, and explain the interrelationships of fi nancial risks in this crisis (12.4) LO 5. describe the evolution of the global fi nancial crisis, its impact on the fi nancial markets and the responses of governments and regulators to the crisis (12.5) LO 6. analyse and discuss the question ‘Will there be another fi nancial crisis in the future?’ (12.6). Once you understand these learning objectives you will be ready to complete the end-of-chapter review questions. Viney - Financial Market Essentials CH12.indd 413Viney - Financial Market Essentials CH12.indd 413 29/7/10 2:17:19 PM29/7/10 2:17:19 PM This document is distributed for marketing purposes only. No authorised printing or duplication is permitted. (c) McGraw-Hill Australia Introduction The great depression that began in the USA in 1929 saw a collapse in the fi nancial markets, a signifi cant economic downturn and severe social ramifi cations associated with very high levels of unemployment. In the wake of this crisis, the USA introduced legislation that was designed to insulate the fi nancial system from this type of crisis in the future. The Glass-Steagall Act of 1933, in part, prohibited commercial banks from owning full-service brokerage fi rms and conducting investment banking activities such as underwriting. By the end of the twentieth century, the separation of commercial banking and investment banking activities was becoming blurred and USA legislators eventually repealed the Glass- Steagall Act. Within a relatively short period, the global fi nancial crisis occurred (see discussion in Section 12.5). Financial historians will discuss this coincidence of events for some time. One of the interesting observations of behavioural fi nance is the tendency for policymakers and managers to forget the lessons of past crises. There seems to be a belief that all is well in the markets and another crisis will not happen—particularly in the current market at the time. Tied in with this belief of invincibility is a willingness to take greater risks in order to continually grow an institution and increase profi t outcomes. The case studies we examine in this chapter are: The failure of Barings Bank o The Asian fi nancial crisis o The global fi nancial crisis. o In each of these crises you will see that underlying each crisis is a failure of risk management policy and practice. That failure sometimes is evident at a government legislative level, prudential supervision level or executive management level within a fi nancial institution. In many fi nancial crises, the failure of risk management policy and practice has allowed a culture of excessive risk taking that is fundamentally motivated by a desire to increase institutional profi ts or performance bonus payments. We will begin our study of fi nancial crises by examining the structure of the global fi nancial markets so that you have an understanding of the context in which modern fi nancial crises may occur. Review points In the USA the Glass-Steagall Act of 1933 was designed to protect the US o fi nancial system from another major fi nancial crisis. As the distinctions between a commercial bank and an investment bank blurred, the Glass-Steagall Act was repealed. Within a relatively short period the global fi nancial crisis occurred. Behavioural fi nance indicates that policymakers and managers often forget the o lessons of past fi nancial crises. Often, fi nancial crises exhibit an underlying failure of risk management and policy o which encourages a culture of risk taking to increase profi ts and performance bonus payments. 414 F I N A N C I A L M A R K E T E S S E N T I A L S Viney - Financial Market Essentials CH12.indd 414Viney - Financial Market Essentials CH12.indd 414 29/7/10 2:17:21 PM29/7/10 2:17:21 PM This document is distributed for marketing purposes only. No authorised printing or duplication is permitted. (c) McGraw-Hill Australia 12.1 Globalisation of the fi nancial markets A nation-state’s fi nancial system is an integral part of the global fi nancial system. An important relationship exists between an effi cient fi nancial system and growth in the real economy within a nation-state. Similarly, as production and international trade between multi- national corporations and governments expanded, so too did the need for a global fi nancial system to support that expansion. Essentially, globalisation refers to the process whereby fi nancial markets are inter- connected, interdependent and integrated. The rapid development and adoption of technology-based information systems, communication systems and product delivery systems have facilitated globalisation of the fi nancial markets and the standardisation of the fi nancial instruments used in the global markets. At the same time, technology has enabled the develop- ment of a whole new range of sophisticated fi nancial instruments that facilitate the movement of funds between surplus units and defi cit units in different nation-states. New markets in risk management products, in particular those using derivative products, have also evolved. While the role of technology in the development of global fi nancial markets is critical, it should be noted that there are a number of other important factors and relationships that impact upon globalisation. These include: Unrestricted movement of capital around the world. Theoretically, the global market o will encourage savings and allocate those savings effi ciently to the most productive purposes without regard to national boundaries. o Deregulation of nation-state fi nancial systems, including the removal of signifi cant regulatory constraints that restrict fi nancial markets, products, participants and pricing. Financial innovation o , to develop new systems, products and services. The need of corporations and governments to diversify their funding sources on a global o scale. Increased competition between fi nancial markets and institutions for the provision of o fi nancial products and services. Exchange rate, interest rate and price volatility within the international markets and o the associated increase in demand for risk management products. Changing demographic and savings patterns. For example, the ageing of populations of o many economies has resulted in the accumulation and mobilisation of greater levels of retirement savings. The development of emerging markets, in particular, parts of Asia, South America and o Eastern Europe. Rapid technological innovation and a more sophisticated business environment, together with longer-term changes in the fi nancial needs of market participants, are reshaping the fi nancial system. A progressively greater array of participants, products and distribution channels have developed (and will continue to develop) the fi nancial system. Competition is emerging from new providers of fi nancial services and through the increasing globalisation FINANCIAL SYSTEM Comprises a range of fi nancial institutions, instruments and markets; overseen by central bank; supervised by prudential regulator GLOBALISATION The integration of fi nancial institutions, instruments and markets into an international fi nancial system DEREGULATION The removal of government regulation that constrained the effi cient operation of competitive fi nancial institutions and markets FINANCIAL INNOVATION The development of sophisticated fi nancial products TECHNOLOGICAL INNOVATION The use of new technology for the delivery of fi nancial product and information systems 415C A S E S T U D I E S I N F I N A N C I A L C R I S E S C H A P T E R 12 Viney - Financial Market Essentials CH12.indd 415Viney - Financial Market Essentials CH12.indd 415 29/7/10 2:17:21 PM29/7/10 2:17:21 PM This document is distributed for marketing purposes only. No authorised printing or duplication is permitted. (c) McGraw-Hill Australia of fi nancial markets. Nation-states are striving to achieve improved market effi ciency and performance. To help understand the drivers for change in a modern fi nancial system, it is benefi cial to refer to the report of an Australian review of the fi nancial system. The Wallis Report, released in 1997, considered the international nature of fi nancial systems and identifi ed four principal areas that directly affect an evolving fi nancial system. These are: Changing customer needs� Technology-driven innovation� Regulation as a driver of change� The changing fi nancial landscape.� 12.1.1 Changing customer needs It is evident that changing population demographics have a major infl uence on the evolution of a fi nancial system. A signifi cant number of nation-states are moving into an extended period in which populations are ageing. At the same time fertility rates have fallen, which in turn will result in higher dependency ratios; that is, a smaller workforce will need to support a larger retired population. This will also place a greater strain on the provision of services by government. The resultant fi nancial system issues that are apparent include: the need for greater asset accumulation by individuals o the implementation of adequate superannuation and retirement savings initiatives and o strategies a signifi cant shift to funds under management, particularly market-linked investments o increased fi nancial advisory services for business and individuals. o Changing work patterns are also evident, with workforces generally becoming more educated as individuals strive to achieve higher qualifi cations to meet the expectations of the business sector. Individuals are tending to work longer hours in an environment in which there may be lower job security. A higher percentage of the workforce may be in part-time employment or self-employed. Another aspect of changing customer needs is an evolving awareness of value and an increasing accumulation of both fi nancial assets and liabilities by the household sector. In an information age, individuals are more aware of, and sensitive to, price competitiveness and changes. At the same time, two contradictory portfolio structural